Opinion Contributor

A new way to run the U.S. economy

A simple reform can prevent monetary policy missing the mark, the author writes. | John Shinkle/POLITICO

Obviously markets aren’t always correct, but on average, economic theory suggests the “wisdom of crowds” beats the forecast of any single institution. In the 1980s, I advocated the creation and targeting of an NGDP futures price. The basic idea is that, instead of setting a target interest rate, as it does now, the Fed will continually adjust the money supply until the markets expect NGDP growth to be on target, say 5 percent annually. One advantage over the current approach is that there is no “zero bound problem,” a.k.a. a liquidity trap. Under interest-rate targeting, the Fed loses the ability to adjust its favorite policy tool when rates hit zero and further monetary stimulus is needed. It’s analogous to a car with a steering mechanism that works fine, except when driving on twisty mountain roads with no guardrail.

There are many versions of NGDP futures targeting, which I explore in my new working paper for the Mercatus Center, but one basic example works as follows: The Fed offers to buy or sell unlimited quantities of NGDP futures at a price equal to the policy target. If investors expect excessive growth, they buy NGDP futures, and the Fed automatically reduces the money supply according to some pre-determined ratio (say by $1,000 for each $1-purchase of NGDP futures). In contrast, if investors see NGDP growth falling below target (as in late 2008) they sell NGDP futures to the Fed, which triggers an automatic increase in money supply. Fed leaders don’t have to guess how much money to add to the economy; the market tells them exactly how much money is needed so that growth in nominal spending is expected to come in at a level consistent with the Fed’s policy goal.

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In less radical versions of the proposal, as developed by economist William Woolsey of the Citadel, the Fed buys and sells NGDP futures at the target price but continues to have discretion over setting monetary policy. The futures market would be one valuable piece of information used in the policymaking process. It would act as a “guardrail,” keeping policy from going off course. If Fed policy is obviously too tight, so many investors will sell NGDP futures short that the Fed will be exposed to the risk of substantial trading losses.

Woolsey’s proposal is analogous to the old gold standard, where central banks promise to convert dollars into gold at a fixed price but still have some discretion as long as they maintain a stable gold price. The advantage of NGDP targeting over a gold standard is that a stable gold price is less likely to provide macroeconomic stability. Why? Because NGDP growth is the sum of inflation and real growth, it picks up both sides of the Fed’s mandate. Thus, in a very real sense, stabilizing an NGDP futures price is equivalent to setting policy at a position where the market expects the Fed to successfully meet its dual mandate. And what could be better than that?